THE RISE OF ESG INDICES
Institutional investors interested in sustainable
investing are increasingly recognising ESG index
tracker funds as a viable, cost effective solution that
offers a practical alternative to the unsustainable
practices of many listed companies across the world.
A trend is starting to emerge in the indexation space in which
the spotlight is fixed on the growth of benchmarks offering
environment, social and governance (ESG) principles-led
mandates. Various factors have motivated for this trend.
For one, the introduction of King III’s principle of integrated
reporting has impelled JSE-listed companies to report on ESG
issues. In addition, Regulation 28 now states that institutional
investors need to consider ESG factors in their investment
This retirement reform by Government has stimulated more
interest in passive investing, and index tracker investment
products in particular. The impact of major corporate scandals,
the 2008 financial crisis and growing awareness of key
sustainability challenges have also increased the focus on
This interest in ESG factors has however not always been so.
Although it is a regulatory requirement to include ESG strategies
when selecting stocks, it was in the past predominately reliant
on the active managers’ discretion. According to a survey
done by Ernst & Young in 2013, the lack of ESG measurement
tools was the main barrier deterring investors from considering
ESG issues. The need for a benchmark became an apparent
need in order to measure ESG application.
ESG indices are specialised analytical tools meant to reflect
the prevalent ESG strategies. They offer an attractive low
cost solution for investors to incorporate sustainability factors
into their portfolios. And the transparency of the screening
process allows investors to clearly understand the pillars being
evaluated and how individual companies are rated to their
peers in the same sector.
In 2004, the Johannesburg Stock Exchange (JSE) became the
first stock exchange in an emerging market to create a socially
responsible investment (SRI) index. The intention was to provide investors with a means of identifying listed companies with sound ESG policies and practices. The index however received much
criticism over the years around lack of transparency, the selection
criteria and underperformance relative to the parent index.
The flawed selection criteria was demonstrated by the inclusion
of stocks like Lonmin and African Bank in the index. And as
the repercussions of the Marikana tragedy played themselves
out and several issues emerged regarding Lonmin’s financial
stability, it continued to be part of the SRI Index. Similarly,
African Bank remained in the index until its suspension in
August 2014. This has left very little confidence from investors
on the quality of the index’s screening.
While SRI is motivated by ethical imperatives to shape the
market, responsible investment needs to be clearly distinguished
from SRI because its particular approach places emphasis
on the financial materiality of ESG issues into mainstream
investment decision making.
The responsible investment approach is therefore not premised
on moral principles, but rather on the principle that ESG risks
can affect the financial performance of investments and they
therefore need to be carefully considered.
As the pioneering indexation managers to introduce a global
ESG capability in both developed and emerging markets, Old
Mutual Investment Group had the expertise and experience to
introduce a sound offering to the local market. And we did.
On 1 April 2016 Old Mutual Investment Group launched the
first responsible investment equity index fund in South Africa,
the Old Mutual Responsible Investment Equity Index Fund.
The Fund invests in companies that have high sustainability
The Fund makes use of the MSCI research methodology and
a best-in-class approach to target sector weights. In selecting
the investment strategy, we consulted our RI team, who are
very familiar with MSCI’s ESG selection process and strongly
endorse this approach.
MSCI was voted the best firm in ESG, corporate governance
and emerging markets research in the 2015 IRRI (Independent
Research in Responsible Investment) Survey. In Contrast
to the aforementioned JSE SRI Index, the robust screening
methodology of our index addressed both the Lonmin and
African Bank issues. Lonmin was excluded from the index due
to a low controversy score, while African Bank was dropped
in June 2014 as their ESG scores were lower than that of their
ANALYSING THE RETURNS
There has long prevailed an alleged trade-off between
investment returns and allocation of capital towards companies
that facilitate positive social and environmental impacts.
Research has however proven that 88% of reviewed sources
find that companies with robust sustainability practices
demonstrate better operational performance, which ultimately
translates into higher cashflows1. And 80% of the reviewed
studies demonstrate that prudent sustainability practices have a
positive influence on investment performance1
Though we cannot guarantee future outperformance, the trend
below (Figure 1) endorses the fact that ESG has paid off
relative to the market index. The returns of the ESG selection
criteria are also far superior to that of the FTSE/JSE SRI SWIX,
which has underperformed the parent index over its lifetime.
The robustness of the screening methodology is once again
reflected in the return profile above. The outperformance of
the Old Mutual Responsible Investment Equity Index Fund was
attributed to two distinct outcomes from the screening process:
A) SABMiller was overweight due to being the best in its
sector from an ESG perspective.
B) Sasol and Anglo American were not selected due to
their low ESG scores and thus the fund benefited as
they have both lost significant value over the period.
We can see a similar trend in emerging economies.
When comparing the MSCI Emerging Markets Index to
that of MSCI Emerging Markets ESG Index (Figure 2),
there is clear value in applying ESG criteria to selecting
the best stocks. Granted, South Africa is a more regulated
emerging economy and the return differential is not as
pronounced as in other emerging economies, however
the data reflects that our market indeed behaves in a
In January both the JSE and S&P launched their Sustainable
Investment indices. We performed research on these
respective indices and found some shortcomings and
hence decided to create our own custom index.
In doing our analysis we looked as the following criteria:
- Research methodology and quality
- Index construction.
The MSCI ESG Research covers 97% of the South African
universe, thus the largest coverage compared with the other
indices, whereas Russell investments cover only the large- and
The Old Mutual Responsible Investment Equity Index Fund uses
a best-in-class approach and thus selects the best 50% in each
sector based on their ESG screening. The FTSE/Russell ESG
Index uses an ESG scoring system where stocks with an ESG
score greater than 2 are included in the index. This hurdle
is very low as almost all stocks in their research universe are
included in the index. S&P, on the other hand, selects the top
33% ESG companies in their universe for selection into the
index, resulting in a very concentrated index of 24 stocks.
The FTSE/Russell is not sector neutral and thus could be biased
to a specific sector. The S&P Index attempts to be sector
neutral, however due to the way their capping methodology
is applied, this objective is negated due to the underweight
position in the industrials sector. From what is illustrated below,
We believe that responsible investing should be transparent
and accessible to everyone on the street and not just large
financial institutions. Having an ESG Index as part of their
investment strategy allows investors to be able to make a
responsible investment choice, be it with their pension fund
or their savings. Today, people care more than ever before
about how financial return is made. Awareness of ESG factors
as being critical in the investment process will only continue to
spread and, as it does so, more and more investors will view
sustainable investing as the new norm. 1 Source: Oxford, Stanford, Maastricht & Arabesque – 2014